Equilibrating Corporate Financial
Engineering and Reporting
Shyam Sunder
Yale University
20th Anniversary Conference on Financial Economics
and Accounting, Rutgers University
November 14, 2009
An Overview
• Let us look at accounting and finance from a social science
perspective
• Objective in corporate financial engineering: to design transactions
to optimize from the point of view of the organization, e.g.,
increase assessed creditworthiness and lower risk based on facts
and appearances of its financial reports
• Objective of financial reporting: to provide information useful for
investment and other decisions by various agents in the economy
• Does the interplay of these two objectives lead to a stable
equilibrium?
• If yes, what is the equilibrium?
• If not, what are the consequences and what, if anything should be
done about it?
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Accounting and Finance as Aspect of
Social Sciences
• These disciplines have been seen from several points of view
• One of them is to think of their topics of substantive interest (e.g.,
corporate finance and reporting, investments, and auditing) as social
phenomena
• Social phenomena are characterized by multiple levels of analysis, e.g.,
macroeconomic, organizational, and individual
• At each level, and across the levels, social phenomena exhibit interaction
among agents (individuals, organizations, and government), learning by
them, feedback effects, and consequently, pervasive endogeneity
• These features of a social science make it more difficult to identify laws or
relationships which are stable relative to their discovery and
characterization (e.g., small firm effect)
• In these few minutes, I would like to discuss one aspect of such
interactions between financial reporting and engineering, and share some
preliminary thoughts about their consequences
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Objectives in Financial Engineering
• “The Financial Engineering Concentration
encompasses the design, analysis, and
construction of financial contracts to meet the
needs of enterprises.” (Cornell’s ORIE M.S.
concentration in financial engineering)
• What are these needs? In at least some cases, these
needs consist of finding ways of
– Reducing indebtedness on the balance sheet, or
– Reducing expense on income statement, or
– Increasing revenue on income statement, or
– Increasing deductions on tax returns
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Securitization according to
International Finance Corporation
• A form of off-balance sheet financing which involves
the pooling of financial assets
• Risk transfer mechanism that allows loan originators to
optimize balance sheet management
• Allows highly rated securities to be created from less
credit worthy assets
• Can be in local or foreign currency, depending on client
needs
• A rapidly growing asset class with proven benefit for
emerging market borrowers
• For summaries of prior deals, please visit
www.ifc.org/structuredfinance
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Financial Reporting Standards as
Constraints on Financial Optimization
• In such optimization, standards of financial reporting are
treated as constraints
• Most optimization problems have hard constraints—their
violation brings well-specified penalties (dual prices)
• With optimization confined by the production possibilities
set and other such physical limitations, external constraints
make a real difference to the final actions
• What kind of constraints do accounting standards offer?
• I am going to argue that these standards offer softer
constraints because the forms of contracts, transactions, as
well as organizational forms that businessmen can devise
and use are beyond the scope of accounting standards
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Redesigning Contracts
• A manufacturer needs to buy a machine for the factory
• Borrowing is an option, but the manufacturer does not
want more debt on its balance sheet
• The leasing subsidiary of a bank buys the machine and
gives it to the manufacturer on a long term lease—
machine is in the factory but no debt on balance sheet!
• FASB writes Standard 13: leases >90%V and >75%T
must be treated as capital leases (debt is back on BS)
• The bank revises the lease to levels below the
thresholds specified in the standard (debt is off the BS)
• FASB goes back to work, and so on … until the rulebook
grows to over a 1,000 pages
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Redesigning Transactions
• Depending on the current standards of
financial reporting, transactions can be
redesigned to achieve the desired
consequences for revenues, expenses and
taxes
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Redesigning the Organization
• When design of contracts and transactions is not
sufficient, organizations themselves can be redesigned,
or new ones created in order to have the desired
consequences for balance sheets, income statements
and tax returns
• Special purpose entities (SPEs and SPVs) are examples
of organizations created for this purpose (see Klee and
Butler 2002 and Gorton and Souleles 2005)
• “Hundreds of respected U.S. companies are ferreting
away trillions of dollars in debt in off-balance sheet
subsidiaries, partnerships, and assorted obligations”
(Henry et al. 2002)
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Asymmetric Game
• Note that financial reporting standards neither have, nor
can have, any say in any of these “business” decisions of
the management
• The role of the accountant and auditor is limited to
preparing financial reports given all these decisions
• While these decisions clearly consider what the accounting
standards are, accountants have little freedom to take into
account how and why these decisions were taken in the
first place
• There is great asymmetry between the freedom available
to the business decision makers and constraints on the
accountant who must abide by relatively rigid written
standards
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The Net Effect
• The decision to write an accounting standard is a matter of social
policy that calls for a deliberative due process; it typically takes
years to determine which rules might best serve investors and
others. Inevitably, these standards are written on the assumption
that the current forms of contracts, transactions, and organizations
will continue to be used in the future when these standards are
applied
• The decision to change contracts, transactions and organization is
an individual decision that may be taken within days if not hours.
Further, the scope of these decisions is virtually unbounded (except
by the imagination of the businessmen). Soon after the standards
are issued, the environment to which they are applied changes
relative to the what the standards were written for
• The net effect: Financial reporting standards serve as relatively
weak constraints (if at all) on what businesses can do
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Three Major Classes of Derivatives
• Futures/Forwards are contracts to buy or sell an asset
on or before a future date at a price specified today.
• Options are contracts that give the owner the right,
but not the obligation, to buy (in the case of a call
option) or sell (in the case of a put option) an asset.
The price at which the sale takes place is known as the
strike price, and is specified at the time the parties
enter into the option ( European vs. American options)
• Swaps are contracts to exchange cash (flows) on or
before a specified future date based on the underlying
value of currencies/exchange rates, bonds/interest
rates, commodities, stocks or other assets.
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Six Types of Underlying Assets
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Interest rate derivatives (the largest)
Foreign Exchange derivatives
Credit Derivatives
Equity derivatives
Commodity derivatives
Weather derivatives
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Over-the-Counter Derivatives
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Traded (and privately negotiated) directly between two parties, without going
through an exchange or other intermediary (e.g., swaps, forward rate agreements,
and exotic options)
This largest of the derivatives market is largely unregulated with respect to
disclosure of information between the parties (banks and hedge funds etc.)
Reporting of OTC amounts are difficult because trades can occur in private,
without activity being visible on any exchange.
According to the Bank for International Settlements:
The total outstanding notional amount is $684 trillion (as of June 2008)[4].
67% are interest rate contracts,
8% are credit default swaps (CDS),
9% are foreign exchange contracts,
2% are commodity contracts,
1% are equity contracts, and
12% are others
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Exchange-traded derivatives
• A derivatives exchange acts as an intermediary to all related
transactions, and takes Initial margin from both sides of the trade to
act as a guarantee.
• The world's largest derivatives exchanges (by number of
transactions): Korea Exchange, Eurex, and CME Group (made up of
the Chicago Mercantile Exchange, the Chicago Board of Trade and
the New York Mercantile Exchange.
• According to BIS, the combined turnover in the world's derivatives
exchanges totaled USD 344 trillion during Q4 2005.
• Some types of derivative instruments also may trade on traditional
exchanges (convertible bonds and/or convertible preferred,
warrants, Performance Rights, Cash xPRTs and various other
instruments that essentially consist of a complex set of options
bundled into a simple package)
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Why Is It So Difficult to Write
Standards for Derivatives Accounting?
• Some derivatives are designed to get around the intent
(provision of information) of the extant financial reporting
standards
• How does one write standards for these instruments?
• Is it possible to have an equilibrium between design of such
instruments and standards for reporting them?
• The problem seems to have gone largely unnoticed in the
flurry of proposals on financial reforms now on the table
• The question is: Are the optimization in financial
engineering (relative to prevailing reporting standards), and
search for standards that provide useful information to
investors mutually consistent goals?
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Social Norms of Accounting and
Finance
• I personally doubt that a non-cooperative game between financial
engineers and accountants has led us to a socially efficient outcome
• Accountants have, over the past eight decades, increasingly come
to rely on written rules as opposed to their judgment and social
norms of their profession
• Financial engineers, on the other hand consider it their own
professional duty to design whatever
instruments/transactions/organizations will best serve the
immediate interests of their clients under the prevailing written
standards of financial reporting
• Social norms play a diminishing, if any, role on either side
• Is it possible that some part of the blame for the systemic failures of
the recent years may be linked to this diminishing role?
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Ethics and Moral Code in Business
Programs
• Shiller: “Many schools now offer a course in business ethics, and
some even try to integrate business ethics into their other courses.
But nowhere is ethics seen as the centerpiece or even integral part
of the curriculum. And even when business students do take an
ethics course, the theoretical framework of the core courses tends
to be so devoid of any moral content that the discussion of ethics
must seem like some side order of overcooked vegetable”.
• If the role of ethics in curriculum is minimal, what is the role of
ethics (i.e., social consequences of our work) in choosing the
substantive topics of our research
• Identifying mispricing of securities, for example, may help move
prices to more efficient levels
• What about identifying a way of redesigning a transaction so a
financial obligation will not show up on the balance sheet under the
prevailing reporting standards?
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Ethics and Moral Code in Research
Programs
• In some recent theoretical and experimental work, we find that the
constraints imposed by financial and social institutions (e.g.,
bankruptcy laws, commercial code, accounting) can help resolve
otherwise mathematically intractable problem of multiplicity of
equilibria in economy. Could this also apply to interaction between
financial engineering and reporting?
• Which one of us would refuse to work on either an optimal
transaction design or accounting standardization problem on ethical
(social consequences) grounds?
• If I were a locksmith, and published the locking codes for the
university doors, I might bear some moral culpability
• Is, or should, there be any moral culpability associated with devising
a way around a standard of financial reporting intended to provide
better information?
• When, and where, should we raise such issues?
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Some Fundamental Issues
• Role of social ethical norms in accounting and
financial institutions
• Reflexivity of markets and of financial reporting
(Keynes, Sunder)
• Rationality can serve as an anchor, not a
description; irrationality offers no explanation
• Fractal structure of knowledge (try for yourself,
e.g.,
http://www.coolmath.com/fractals/fractalgenera
tors/generator1/index.html)
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Roles of Accounting and Finance
Research
• Progressive “micronization” of research
• Progressive shift in research attention to better
explanatory power through additional variables
• This process is understandable, but does not
create a micro-macro issues balance
• Discarding of details, standing back, to allow a big
picture to emerge is just as important
• What is the big picture of corporate financial
reporting and engineering today?
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In Summary
• Accounting and finance originated as a single discipline
have increasingly diverged in the recent decades
• Interaction of financial reporting standards on one
hand and financial engineering on the other has
created a newer kind of interaction between them with
its own special consequences
• What, if any thing, should we, and can we do about
this?
• Are there some alternatives to bringing in a sense of
social responsibility for the consequences of our
research agendas? If so, let us explore them.
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References
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Hans J. Blommestein, “The Financial Crisis as a symbol of failure of academic finance (a
methodological digression), The Journal of Financial Transformation, Fall 2009.
G. Gorton and N. Souleles, “Special Purpose Vehicles and Securitization,” FRB Philadelphia Working
Paper, 2005.
Henry, David, Heather Timmons, Steve Rosenbush, and Michael Arndt (2002), “Who else is hiding
debt?,” Business Week (January 28), 36-37.
J. Huber, M. Shubik, and S. Sunder, “Default penalty as disciplinary and selection mechanism in
presence of multiple equilibria,” Cowles Foundation Working Paper 1730, October 2009.
K. Klee and B. Butler, “Asset-Backed Securitization, Special Purpose Vehicles
and Other Securitization Issues,” Uniform Commercial Code Law Journal 35 (2002), 23-67.
J. Mason, E. Higgins and A. Mordel, “Asset Sales, Recourse, and Investor Reactions to Initial
Securitizations: Evidence Why Off-balance Sheet Accounting Treatment Does not Remove Onbalance Sheet Financial Risk” LSU Working Paper, 2009.
Robert J. Shiller, “How Wall Street learns to look the other way,” The New York Times, Feb. 8, 2005.
Shyam Sunder. Theory of Accounting and Control. Southwestern Publishing, 1997.
Shyam Sunder, “Determinants of Economic Interaction: Behavior or Structure.” Journal of Economic
Interaction and Coordination 1, no. 1 (May 2006): 21-32.
Shyam Sunder, “’True and Fair’ as the Moral Compass of Financial Reporting,” in Cynthia Jeffrey, ed.,
Research in Professional Responsibility and Ethics in Accounting (Forthcoming 2009).
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Thank You.
Shyam.sunder@yale.edu
www.som.yale.edu/faculty/sunder